page 1 international finance lecture 6. page 2 world financial markets and institutions...

International Finance

Lecture 6

World Financial Markets and Institutions

• International Banking and Money Market

• International Bond Market• International Equity Markets• International Portfolio Investment• Futures and Options on Foreign

Exchange• Currency and Interest Rate Swaps

International Portfolio Investment

• International portfolio ________________• Portfolio theory and _______________ investment• International mutual funds

– International diversification through country _____

– International diversification through __________

– International diversification through __________

• Home ____________

Portfolio return

• Investment in international securities offer opportunities for ______________ but increases foreign exchange ____________;

• For example, – A Canadian portfolio manager buys 10 UK

shares at £10 per share, at $2.30/£;– At the end of the period, the shares have risen

in value to £110, but the pound falls to $2.10/£:

Portfolio return• Three rates of return:

Portfolio risk• Two sources of uncertainly

– Stock return volatility– Exchange rate volatility

FXstockstock ,2

change rate FX2

return investment nalinternatio 2

Portfolio risk and return• You are investing into a stock in the emerging market. The

stock return is expected to be 30% and the standard deviation of the return is estimated 45%. The foreign currency is expected to depreciate by 10% during the following year, with estimated 20% standard deviation of the currency depreciation. The correlation between stock returns in that country and the exchange rate changes is estimated -0.09.

• What are the expected return and risk of holding this stock, in $?

• What is the probability that you will lose money? … earn no more than the current $ riskless rate of 5% on this investment? … probability that you will earn return between 5% and zero ? Assume normal distribution.

Portfolio risk and return

Portfolio theory and international investment

• Returns are not perfectly correlated with exchange rates. Under certain conditions stocks:– Less risky for international investors than for domestic

investors.– i.e.

– Provide higher returns for international investors than for domestic investors

– i.e.

• International investments offer greater investment opportunities compared to domestic investments

Markowitz Efficient frontier• Portfolio risk and return

– Mean portfolio return ___________– Portfolio variance _____________

• Mean-variance efficiency– For any combination of stocks, it is possible to

construct a portfolio that will give the __________ return for a given level of risk, or the lowest risk for a given _________ of required return

• Capital Allocation with lending/borrowing– If you use a riskless asset in your investments,

or if you ___________, it is possible to achieve higher returns compared with the case when you do not use riskless investment / borrowing

Markowitz Frontier and CML

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

0.00% 50.00% 100.00% 150.00% 200.00% 250.00% 300.00%

Stdandard Deviation

Ret

urn

Markow itz Eff icient Frontier CALActual spreadsheet. Double-

click on graph and go to sheet “Markowitz” to see

calculations.

International Portfolio Diversification

Optimal International Portfolio Selection• Security returns are much less correlated across

countries than within a country.– __________, ___________, __________, and even _________ factors

affecting security returns tend to ____ across countries, resulting in low correlations among international securities.

• The correlation of Canadian stock markets with the returns on the stock markets in other nations varies.– The correlation of the U.S. stock market with the Canadian

stock market is 58%.– The correlation of the U.S. stock market with the Japanese

stock market is 26%.– A U.S. investor would get ________ diversification from

investments in Japan than Canada.

CAN$ - Based Equity Correlations

Summary Statistics for Monthly Returns for 12 Major Stock Markets

1/1980-12/2001

Domestic v. International Diversification

Optimal Portfolio Investment • Various ways to optimize, the text suggests the

following technique:– ______________ portfolio’s Sharpe Ratio subject

to the following:1. Portfolio _________ = weighted average return2. Portfolio ____________ = [ΣiΣjσij]0.5

3. Constraints:

• Sum of ____________ weights xi= 1

– Obtain optimal weights for each country’s stock market index and call them OIP weights, OIP – optimal investment portfolio

Composition of the OIP for a Canadian Investor

Hong Kong market

3.31%

Italian market 2.62%

Netherlands market

28.53%

Swedish market 23.92%

U.S. market 41.62%

Total 100.00%

OIP by Investors’ Domicile (1980-2001)

International Mutual Funds: • An investor can easily achieve international

diversification by investing in international mutual fund. View HSBC funds

• The advantages include1. __________ on ____________ and ___________ costs.2. Circumvention of legal and institutional ___________ to

direct portfolio investments abroad.3. Professional _____________ and record ___________.

• A country fund invests exclusively in the stocks of a single county. This allows investors to:1. Speculate in a _________ foreign market with minimum cost.2. Construct their own ___________ international portfolios.3. Diversify into ___________ markets that are otherwise

practically inaccessible.

International Mutual Funds: A Performance Evaluation

American Depository Receipts

• Foreign stocks often trade on U.S. exchanges as ADRs.• It is a receipt that represents the number of foreign

shares that are deposited at a U.S. bank.• The bank serves as a _________ agent for the ADRs

• There are many advantages to trading ADRs as opposed to direct investment in the company’s shares:– ADRs are in U.S. dollars, trade on U.S. exchanges and

can be bought through any broker.– Dividends are paid in U.S. dollars.– Most underlying stocks are bearer securities, the ADRs

are registered.

i Shares

• World Equity Benchmark Shares (WEBS)– Country-specific _________ of stocks designed

to replicate the country indexes of 14 countries.

– WEBS are subject to U.S. SEC and IRS diversification _______________.

– Low ____________, convenient way for investors to hold diversified investments in several different countries.

• Re-named into iShares in 2000.

The Home Bias in Equity Portfolios

Country Share in World Market Value

Proportion of Domestic Equities in Portfolio

France 2.6% 64.4%

Germany 3.2% 75.4%

Italy 1.9% 91.0%

Japan 43.7% 86.7%

Spain 1.1% 94.2%

Sweden 0.8% 100.0%

United Kingdom 10.3% 78.5%

United States 36.4% 98.0%

Total 100.0%

Why Home Bias in Portfolio Holdings?

• Three explanations come to mind:1. Domestic equities may provide a

superior _____________ hedge.2. Home bias may reflect institutional and

legal ___________ on foreign investment.

3. Extra taxes and transactions/information costs for __________ securities may give rise to home bias.

Example• You are a French investor holding a portfolio of US bonds.

Over the month, the value of your portfolio increases from $1 million to $1.05 million. The exchange rate moves from 1.00 EUR/USD to 1.02 EUR/USD. (i) what is your rate of return in dollars? (ii) what is your rate of return in Euros? Is the difference exactly equal to the percentage movement in the exchange rates, and why?

ExampleConsider a Canadian pension fund with the following characteristics:

% investedTotal $ Return

Std. Dev. of Dollar Return

Correlation with Canadian Stock Index

Canadian equity 90% 10% 15% 0.99

Foreign Equity 10% 11% 20% -0.10

Is the risk-return of the foreign portfolio attractive?

Taxes• Types of taxation• Tax environments• Tax planning

Example• On June 1, 2005 you bought a 182-day T-bill at a price of

97.905 of its maturity value. Your average tax rate is 26.5% and you marginal tax rate of 33.0%. What is your after-tax EAR on the T-bill?

Example• What is the after-tax real rate of return on this

t-bill for a person whose marginal tax rate is 48%? Inflation rate is 3%.

• Assume that interest rates do not change during the year and there is opportunity for re-investment at the same rate.

Types of Taxation

• Income Tax• Withholding Tax• Value-Added Tax• Other taxes

Income Tax

• An income tax is a tax on __________ and ___________ __________.

• Many countries in the world obtain a significant portion of their tax _________ from income taxes.

• An income tax is a _________ tax, that is one that is paid directly by the taxpayer upon whom it is levied.

Corporate Income Tax Rates inSelected Countries

10

15

20

25

30

35

40

45

50

Rate

Withholding Tax

• Withholding taxes are withheld from the payments a corporation __________ to the taxpayer.

• The taxes are levied on __________ income earned by an individual or corporation of one country within the tax jurisdiction of another country.

• Passive income includes dividends and interest income, income from royalties, patents, or copyrights.

• A withholding tax is an ____________ tax.

Value-Added Tax

• A value-added tax (_______) is an indirect national tax levied on the value added in production of a good or service.

• In many European and Latin American countries the VAT has become a major source of taxation on private citizens.

• Many ________________ prefer a VAT to an income tax because the incentive effects of the two taxes differ sharply.

Value-Added Tax

• An income tax has the incentive effect of discouraging _________.

• A VAT has the incentive effect of discouraging ___________ (thereby encouraging saving).

• VAT’s are easier to administer as well. While taxpayers have an incentive to hide their income, producers have an incentive to make sure that their upstream suppliers in the production process declare the value added (and pay the tax!).

Value-Added Tax Calculation

In this example, the tax rate is 15 percent. Suppose that stage one is the sale of raw materials to the manufacturer; stage two is the sale of finished goods to a retailer; stage three is the sale of inventory from the retailer to the consumer.

Production Stage

Selling Price

Value Added

Incremental VAT

1 €100 €100

2 €300 €200

3 €380 €80

Total VAT

Other Types of Taxation

• A __________ tax is a tax levied not on income but on the wealth of a taxpayer. __________ taxes are an example.

• A poll tax is a tax on your _____________. It is so called because it was collected from those who wished to vote.

The National Tax Environments

• Worldwide Taxation– Tax national residents of the country on their

worldwide income no matter in which country it was __________;

– Creates the _____________ for double taxation.• Territorial Taxation

– Territorial taxation tax residents based upon __________ the taxable event occurred.

• Foreign Tax ___________

Foreign Tax Credits• Allows taxpayers to recover somewhat

from _________ taxation.• Direct foreign tax credits are computed

for direct taxes ______ on active foreign-source income of a foreign branch of a MNC or on withholding taxes ________ from passive income.

• Indirect foreign tax credits are for income taxes ______________ by the subsidiary.

Organizational Structures for Reducing Tax Liabilities

• Branch & Subsidiary Income• Payments to and from Foreign

Affiliates • Tax Havens

Branch & Subsidiary Income

• An overseas affiliate of a MNC can be organized as a _______ or a ____________.

• A foreign branch is not an independently incorporated firm separate from the parent.– Branch income passes ____________ through to

the parent’s income statements.• A foreign subsidiary is an affiliate

organization of the MNC that is independently incorporated.– Income may not be _________ in domestic

country until it is ______________, under certain circumstances.

Foreign Corporations

• US tax law– _______________ foreign corporation

• ______ < ownership stake < ________• Active and passive income taxed only when

remitted to parent in the _________________

– Controlled foreign corporation• _________ < ownership stake • Active and income taxed only when

__________ to parent, passive income taxed when ________ even if not remitted to parent

Transfer pricing• Having foreign affiliates offers transfer

price tax arbitrage strategies.• The transfer price is the accounting value

assigned to a good or service as it is transferred from one affiliate to another.

• If one country has ______ taxes, don’t recognize income there—have those affiliates pay _________ transfer prices. If one country has _________ taxes, recognize income there—have those affiliates pay ________ transfer prices.

Tax Havens

• Tax havens are countries with ______ corporate income tax rates and ______ withholding tax rates on _________ income.

• Tax havens were once useful as ___________ for a MNC to establish a shell company.

• Continue with Lecture 7 if time permits

page 1 international finance lecture 6. page 2 world financial markets and institutions...

Documents

mean portfolio return

international investors

international investments

portfolio theory

portfolio variance

international securities

expected return

rates of return